Intertemporal choice

Lecture 5 Tom Holden Intermediate Microeconomics Semester 2

http://micro2.tholden.org/

ECO 2051 Intermediate Microeconomics

Objectives for this topic

To understand and use (net) present values. To appreciate the budget constraint that individuals face when choosing between consumption over time. To show how choices are affected by individuals preferences between consumption today and tomorrow. To relate this analysis to borrowing and saving behaviour.

ECO 2051 Intermediate Microeconomics

Readings
Varian, Chapter 10 MKR, Chapter 5

ECO 2051 Intermediate Microeconomics

Thinking about intertemporal choice

Intertemporal choice: choice over levels of consumption over time. E.g.:
Given people usually receive income in monthly lumps, how should the income be spread over the following month?
How much should we save for retirement? Is it rational to take out student loans? When should firms invest in a project that pays off in the future?

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Think about your intertemporal choices

Did you save before you came to university? Are you borrowing?
At what rate of interest?
Does your borrowing change depending on the rate of interest you face?

To what extent do you think about your future income when making these decisions?
Do you think your consumption decisions will change if you get a definite job/placement offer?
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Present and future values

Suppose period 0 is the present. is the interest rate per period.
E.g. If = 0.1 = 10%, then 100 saved in period 0 becomes 110 in period 1. More generally, saving in period 0 means you have 1 + in period 1. If you keep your money in savings until period , you have 1 + .

What is the value today of in period 1?

It must be less than , as if you took that now and invested it you would have 1 + in period 1. Instead the present value (PV) in period 0 of in period 1 is 1+, since if you invest this amount at 0 you get at 1. More generally, the present value in period 0 of in period is 1+ .
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Example present values

Present values reduce quite fast as we look further into the future under reasonable interest rates.

Value of years in the future under different interest rates

Rate 0.05 0.10 0.15 0.20 = .95 .91 .87 .83 = .91 .83 .76 .69 = .78 .62 .50 .40 = .61 .39 .25 .16 = .48 .39 .25 .16 = .37 .15 .06 .03 = 25 .30 .09 .03 .01 = 30 .23 .06 .02 .00

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More complicated present values

Suppose you believe buying a share in a company (in period 0) would give you a stream of dividends given by 1 , 2 , where is the dividend you get in period .
What is the present value of this dividend stream? It is the PV of getting 1 in period 1 plus the PV of getting 2 in period 2, plus
I.e.
1 1+ 1

2 1+ 2

+=

=1 1+

So at what price should you be prepared to buy the share? What should you do if you couldnt afford it at this price?

Note that high interest rates reduce present values.

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More on present value (1/4)

Suppose a consumers income stream is currently given by 0 , 1 , 2 , where is their income at , and period 0 is the present.

If they are offered the chance to switch to an alternative stream 0 , 1 , 2 , should they take it?
Could be a new job, or a degree, or an investment.
1 PV of the original stream, is = 0 + 1+ +

2 1+ 2

+=

=0 1+ .
=0 1+ .

1 PV of the alternative stream, is = 0 + 1+ +

2 1+ 2

+=

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More on present value (2/4)

Suppose that > and they do take the stream.
1 Then, by going to the bank they can borrow 1+ against their period 1 1 income. (When period 1 arrives they will have to repay 1+ 1 + = 1 , 2 which is their period 1 income.) And 1+ 2 against period 2 income, etc etc.
So they can borrow 1+ = 0 in total (note sum starts at 1), so if =1 they wanted to they could spend in period 0 and starve from then on.

Suppose they borrow all of this money, then immediately put a total of =1 1+ = 0 into their saving account, leaving 0 = + 0 in their pocket.

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More on present value (3/4)

As > 0, this enables them to spend more than 0 in the first period. The next period thanks to interest they now have 1 +
=2 1+ 1 =1 1+

= 1 +

in the bank.
=2 1+ 1

If they spend 1 they still have

in savings. = 2 +
=3 1+ 2 .

The period after this has become 1 +

=2 1+ 1

Continuing in this way, the consumer may spend in every period after 0.

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More on present value (4/4)

But they spent more in 0, thus consumption is higher in one period, and the same in all others, so the consumer must be better-off overall, as long as their preferences are strictly increasing.

So when > the consumer is strictly better off taking the stream, independent of preferences.
As Varian says:
Present value is the only correct way to convert a stream of payments into todays dollars If a consumer can freely borrow and lend at a constant rate of interest, then the consumer will always prefer a pattern of income with a higher present value to a pattern with a lower present value.

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PV examples: Comparing two simple income streams

Investment A pays 100 now and 200 next year. Investment B pays 0 now and 310 next year.

With a zero interest rate we just add up the payments 310 > 300 so investment B is better.
But with a sufficiently high interest rate investment A is preferred.
For example if = 0.2 then PV = 100 + 258.33.
200 1.2

= 266.67 & PV = 0 +

310 1.2

The fact that A pays more money earlier on means that it will have a higher present value if the interest rate is high enough.
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PV examples: Perpetuities
Buying a perpetuity guarantees the holder of the perpetuity to a payment of in all future periods. What is the PV of such a perpetuity?
Using the formula from earlier, the present value of the perpetuity, , satisfies = = + + =1 2 3 + .
1+ 1+ 1+ 1+

Thus 1 + = + 1+ + So = , i.e. = .

1+ 2

+ = +

If you invest an amount at an interest rate , then you get each period.

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PV examples: Bonds
Buying a -period bond guarantees the holder to:
A payment of in periods 1,2, , 1. (This is called the coupon.) A payment of in period . (This is called the face value.)

Thus the present value of the bond, , satisfies:

1

=
Thus:
=1

1 +

1 +

+ 1 + 1 +

+ + 2

1 +

+ 1

1 +

+ + + + 1 + 1 + 2 1 + 2 1 + 1 = + + + + + + 1 + 1 + 2 1 + 2 1 + 1 1 + = + + 1 + 1 1 + 1 + = +

1 + 1 1 +

So = +

1+ 1

1+

= +

1+ , 1+

i.e. = +

1+

1+

.
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PV examples: Investment with maintenance payments

Suppose I buy a machine at a price 0 today, but in each future period it needs maintenance which costs . The machine generates output worth in each period .

Then my net income in period is . And the net present value (NPV) of the investment is the PV of the net incomes, i.e. . =0
1+

The investment is a good idea if the NPV is positive.

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PV examples: Cost benefit analysis

Cost benefit analysis (CBA) works on exactly the same principles as the investment analysis we have just seen. If for some policy the net present value to society is positive, then the policy is worth pursuing.
But here all the benefits and costs are included, and an attempt is made to value them as those experiencing them would value them (so market prices are not always used if externalities etc. are important). is consdered more broadly as the social rate of time preference.
May differ quite substantially from the interest rate. E.g. in Stern report was 2%. Much lower than businesses would use.

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PV examples: Intertemporal budget constraints (2 period case)

0 is consumption in period 0, 1 is consumption in period 1. 0 is the price of the consumption good in period 0, 1 is its price in period 1. 0 is income in period 0, 1 is income in period 1. The budget constraint says the PV of expenditure must equal the PV of consumption.
I cannot die with debts, and I do not want to leave any assets behind when I die.

I.e. 0 0 +

Increasing interest rates make next periods consumption cheaper. (I have to save less today to pay for it). Increasing interest rates make next periods income less valuable. (I can borrow less today using it).

1 1 1+

1 = 0 + 1+.

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The intertemporal budget constraint

is income (i.e. what we were calling .)

When 0 = 1 , the slope of the budget constraint is (1 + ) for each 1 given up now, we get 1 + in future. For each extra 1 consumed now, we give up 1 + in future.
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Preferences

A person who was totally indifferent between consumption today and in the future would have indifference curves with a slope of 1. People are likely to prefer a mix of consumption in present and future, so ICs are convex. Because impatient individuals prefer to consume today, on the 45 line we need more than 1 tomorrow to give up 1 today. Steeper indifference curves imply more impatience.
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Making choices

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Other outcomes

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Example
Suppose:
0 , 1 = 0 1 , 0 = 1 = 1 (i.e. we are measuring in units of the consumption good). the consumer has income of 100 in the first period and 121 in the second, the interest rate is 10%.
0 1

MRS is

= 1.
0

The price of consumption in period 0 in units of consumption in period 1 is 1.1.

This is minus the slope of the budget constraint.

Thus 1 = 1.1 at an optimum, i.e. 1 = 1.10 .

The budget constraint says 0 + 1 = 100 + . 1.1 1.1 Thus 20 = 100 + 110, so 0 = 105 and 1 = 115.5.
So the consumer borrows 5 in the first period and pays it back in the second.

121

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General case (1/2)

The Lagrangian for the consumers optimisation problem is: 1 1 1 = 0 , 1 0 0 + 0 1 + 1 +

FOC 0 : 0 =
FOC 1 : 0 = 1 +
0 1

0 1

0 , so =

1 , 1+

1 0 0

so:

= MRS

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General case (2/2)

Suppose that 1 = 1 + 0 , where is the inflation rate of all prices in the economy.
I.e. the real price of the good has stayed the same.

Then the condition from the last slide says: 1+ = MRS.

This suggests that 1+ is the real cost of substituting between period 0 and 1, i.e. it is one plus the real interest rate. So lets define the real interest rate by = Then the condition says: 1 + = MRS.
1+ 1+ 1+

1+

1=

1+ 1+

1+ 1+

1+

So if the real price of a good is constant, at the optimum minus the slope of the indifference curve must equal 1 + .
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Class exercise: Time-separable utility

Suppose that 0 , 1 = 0 +
1 1+

1 .

is the discount rate. Large means more impatience.

Derive the FOC. When are consumers neither savers or borrowers? What happens when = log ?

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Income and substitution effects

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Comparative statics saver 1

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Comparative statics - saver 2

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The impact of taxing interest

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Applications of intertemporal decision making: human capital investment

If education leads to higher wages later in life then studying can be regarded as an investment. As before, there are a stream of benefits and a stream of costs. By being here you have implicitly calculated that the NPV of this investment is positive(?!?).

It is clear that a number of factors should influence this decision.

The cost of fees. Available borrowing arrangements (students currently pay below the market rate of interest). Income foregone when studying. Expected income on graduation.
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A representation of the investment decision with no credit markets

Notice that here the that human capital options are entirely continuous. This is probably not the case in reality.
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Human capital investment with borrowing and lending

In this example the decision over investment is entirely separate from preferences about consumption over time. Is this plausible? ECO 2051 Intermediate Microeconomics

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Summary
In a world with perfect credit markets consumers can choose between consumption today and in the future.
This is relevant for their saving and borrowing behaviour, and the approach to investments. However, all these decisions will be affected by the relative price of consumption in different periods as indicated by the interest rate.

NPV is an important concept which enables individuals to evaluate the worth of income and payments at different times.
When making decisions we should be choosing those with the highest net present value.

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